ETLA ELINKEINOELÄMÄN TUTKIMUSLAITOS THE RESEARCH INSTITUTE OF THE FINNISH ECONOMY Lönnrotinkatu 4 B Helsinki Finland Tel Telefax World Wide Web: Keskusteluaiheita Discussion papers No Jukka Lassila Tarmo Valkonen THE FINNISH PENSION REFORM OF 2005 Forthcoming in Geneva Papers on Risk and Insurance The paper is part of the European Commission s research project Demographic uncertainty and the sustainability of social welfare systems (QLK6-CT ). We also acknowledge the financial support from the Ministry of Social Affairs and Health and the Finnish Centre for Pensions. We are grateful to Heikki Palm for the advice and support. We also thank Peter Biström, Anthony de Carvalho, Seija Ilmakunnas, Niku Määttänen, Juha Rantala, Ismo Risku, Eila Tuominen, Reijo Vanne and an anonymous referee for comments and Eija Kauppi for the model programming. ISSN LASSILA, Jukka VALKONEN, Tarmo, THE FINNISH PENSION REFORM OF Helsinki: ETLA, Elinkeinoelämän Tutkimuslaitos, The Research Institute of the Finnish Economy, 2006, 20 p. (Keskusteluaiheita, Discussion Papers, ISSN, ; No. 1000). ABSTRACT: A major reform in the Finnish private-sector earnings-related pension system came into effect on January 1 st, It was negotiated in between the central organisations of employers and trade unions and representatives of the central government. This paper describes the reform and analyses its effects on selected macroeconomic variables, on the pension system and on the position of different birth cohorts and different educational groups. The reform appears to be successful in many respects. It simplifies the private-sector pension system and makes it a model that other pension systems in Finland will converge to. The reform rewards postponing retirement. It curbs the increase in contribution rate without endangering the adequacy of replacement rates. The increase in labour supply will have beneficial welfare effects. The new system also responds rather well to uncertain future demographics. Despite this apparent success of the reform there remains a serious doubt of its adequacy, as contribution rates are still expected to rise by several percentage points. KEY WORDS: pension reform, population ageing, stochastic population simulations JEL classifications: H55, J11 LASSILA, Jukka VALKONEN, Tarmo, THE FINNISH PENSION REFORM OF Helsinki: ETLA, Elinkeinoelämän Tutkimuslaitos, The Research Institute of the Finnish Economy, 2006, 20 s. (Keskusteluaiheita, Discussion Papers, ISSN, ; Nro. 1000). TIIVISTELMÄ: Tutkimus analysoi vuoden 2005 alusta voimaan tulleen yksityisen sektorin eläkeuudistuksen vaikutuksia kansantalouteen, työeläkejärjestelmään sekä eri sukupolvia ja koulutusryhmiä edustavien kotitalouksien hyvinvointiin. Uudistus on monella tapaa onnistunut. Se yksinkertaistaa yksityisalojen eläkejärjestelmää ja toimi esimerkkinä julkisten alojen uudistukselle. Se kannustaa jäämään myöhemmin eläkkeelle. Lisäksi se vaimentaa eläkemaksun nousua heikentämättä etuuksia. Työllisyyden paranemisella on laajemmalti hyötyä koko taloudelle. Uusi järjestelmä reagoi myös aiempaa tasapainoisemmin väestökehityksen potentiaalisiin yllätyksiin, joita tässä tutkimuksessa tarkastellaan stokastisten simulaatioiden avulla. Vaikka kokonaisarvio uudistuksesta on myönteinen, uudistus ei tee yksityisalojen eläkejärjestelmästä rahoituksellisesti kestävää, koska maksujen odotetaan vielä nousevan merkittävästi. ASIASANAT: Eläkeuudistus, väestön ikääntyminen, stokastiset väestösimulaatiot 1. Introduction A major reform of the Finnish private-sector earnings-related pension system was agreed on in The agreement was justified by the need to mitigate rising pension costs due to population ageing, similar to arguments spurring many other recent reforms in Europe. The large reform package consists of an interesting combination of measures that were expected to improve both the economic and social sustainability of the pension system. The main aims of the reform are to postpone the average retirement age, curb the expected increases in contribution rates and to support ageing workers ability to cope with their work. A further initial and widely supported target was to simplify the pension rules and make them both more transparent and more actuarial. The first aim is promoted by rewarding continued participation in working life and by restricting access to early retirement schemes. In addition to the benefits gained from later retirement, the reform strengthens financial sustainability by starting to apply life expectancy adjustment to the accrued pension rights. The agreement was a compromise between central organisations of employers and trade unions and representatives of the central government. Interestingly, the main disagreements were between various trade unions, see Lassila (2004). In addition to preserving the vested interests of the unions, some details of the agreement reflect the aim of protecting the generations near retirement from abrupt changes in pension rules. The reform has been analysed earlier with an actuarial model by Biström et al. (2004) and verbally by Börsch- Supan (2005). The longer policy line of fostering employment among older workers in Finland has been discussed profoundly by Ilmakunnas and Takala (2005). We analyse the reform using a numerical modelling framework, which allows simulating the interaction of the changed pension rules, households reactions to those changes and the adjustment process in various markets of the economy. We aim first to give an extensive view of the expected effects of the reform in terms of macroeconomic outcomes, pension system variables and household incomes by birth cohort and education. The sustainability aspect is assessed by using a large amount of sample populations from a stochastic population forecast as inputs in the economic model, thereby creating probability-based descriptions for future paths of the contribution and replacement rates. A similar type of numerical overlapping generations model has been used to analyse pension reforms by, e.g., Kotlikoff et al. (1998) and Fehr (2000). The method of analysing both financial and social sustainability with stochastic population simulations was earlier used by Alho et al. (2005) in a study of the Lithuanian pension system. The remainder of the paper is organised as follows. Section 2 presents the Finnish pension system and the changes it will likely undergo as a result of the reform. Section 3 describes the methods we use. Section 4 describes the expected impacts of the reform. In Section 5 demographic uncertainty and its consequences for the risks faced by workers and pensioners are discussed. Concluding comments are provided in Section 6. 2 2. Description and general assessment of the private sector pension reform The Finnish pension system consists of two main parts. The earnings-related pension system aims to provide retirement income sufficient to cover consumption comparable to levels enjoyed during working years and to current workers consumption. It covers risks related to old age, disability, long-term unemployment of ageing workers, and death of family earners. The national pension guarantees a minimum income in cases where the earnings-related pension is absent or insufficient. Both these first pillar systems are mandatory. Voluntary pensions, whether employer-based or industry-wide supplementary pensions (second pillar) or personal pension arrangements (third pillar), are becoming more common but still of minor importance in Finland. The Finnish earnings-related system is statutory by law but largely privately run. It has collected substantial funds to smoothen the contribution increases due to population ageing in the future. Funding is collective but based on individual pension rights. Individual pension benefits do not depend on the existence or yield of funds. Funds only affect contributions. When a person receives pensions after the age of 65, his/her funds are used to pay that part of the pension benefit that was prefunded. The rest comes from the PAYG part, the socalled pooled component in the contribution rate. A more detailed presentation of the system can be found in Hietaniemi and Vidlund (2003). The latest major reform, agreed in , mainly took effect from the beginning of The main aims of the pension reform are to reward continued participation in working life and postpone the average retirement age, to take increasing life expectancy into account, to curb the expected increases in contribution rates, and to support ageing workers ability to cope with their work. The initial targets of social partners and the state were not explicitly stated before the negotiations, but reducing the expected future increases in contributions certainly was one target and postponing retirement was considered as the main instrument or sub-target in achieving it. One initial and widely supported target was to simplify the pension rules and make them both more transparent and more actuarial. Below we describe the old system in some detail and depict and discuss changes due to the reform. Earlier every employment contract and self-employment period added to the pension after the age of 23. The pensionable wage was aggregated over the last 10 years of each contract. The accrued pension right was vested, even if one changed jobs or stopped working. Following the reform, accrual now starts at the age of 18. Instead of using employment contracts and the pensionable wage concept, every year s earnings and accrual rates directly affect the future pension (the career model). The target level of benefits used to be 60 % of wages. This accrued in about 40 years: 1.5 % per year between ages 23 and 59 and 2.5 % per year between 60 and 65. There was no upper absolute limit to benefits, but an upper percentage limit was 60 % of the highest pensionable earnings. The reform removed this ceiling. The accrual rate is 1.5 % per year between ages 18 53, 1.9 % per year between ages and 4.5 % per year between ages The 4.5 % accrual rate is aimed to reward later retirement in a cost neutral way. 3 Disagreements between different trade unions led to these different accrual rates for employees of different ages. The previous system favoured those with both long employment contracts and rising wage-age profiles, typically white-collar workers with higher salaries. For them, the whole accrual percentage was applied to the last high wages of the career. Moving to a system where each year of the career weighs the same would weaken their relative position. The negotiated result was a compromise, where the latter years of the work career still matter more than the earlier years. Pension rights and benefits are index-linked, previously with weights on wages and consumer prices, respectively, during working years and weights after age 65. After the reform the change in indexation takes place at actual retirement, irrespective of age. The respective weights before retirement are and after retirement. When wages over the entire career affect the pension, the role of indexing becomes more significant. A move from to weights on wages and consumer prices is likely to overcompensate for the effect that early career wages will be more important and late career wages less important than before the reform. Contributions are collected from both employers (on average 16.8 % of wages in 2004) and employees (4.6 %). Future changes have been agreed to be shared between employers and employees. After the reform employees aged 53 and over pay contributions that are about 1.27 times higher than that of younger employees, reflecting their higher accrual. This increase in employee contribution rate does not suffice to finance their increased accrual, which in the future means higher contributions for both employers and all employees. This creates a generational effect: those reaching 53 in 2005 or thereabouts will benefit from the higher accrual but retire before it really affects the contribution rates. The reform brought the Swedish-type longevity adjustment coefficient into the pension system. It will start cutting monthly pensions for all cohorts reaching the age of 62 in 2010 or later. The effects of such an adjustment in Finland had been previously considered in at least two studies (Lindell 1999, Alho 2003 and Lassila and Valkonen 2003). The last of these includes also generational effects. The effects depend on how much life expectancy will actually increase. There has been some consensus among Finnish decision-makers that people should not retire as early as they now do. The target of raising the age of retirement currently ranks high on the agenda in the debate amongst pension policy experts in all European countries. Unfortunately, however, this proposal is very unpopular amongst citizens. A survey (European Commission, 2004) conducted in September October 2001 showed that raising the retirement age is favoured by only 23% of the public, whilst 69% express disagreement (the rest do not know). The Finnish numbers were very close to these EU-15 averages. The average retirement age in Finland is currently somewhat below 60 years. The reform introduced major changes to the pre-retirement pensions. The unemployment pension is gradually being abolished and the lower age limit for entitlement to continued unemployment allowance was increased. Also, age limits for the part-time pension and the early old-age pension were increased and the individual early retirement pension was abolished. The new flexible retirement on an old-age pension takes place between ages 62 and 68. 4 Labour force participation rates of older people are likely to increase following the changes to the pre-retirement pensions in the pension reform. Also, the change in accrual rates for those over 62 provide better incentives to continue working for persons with short work career and thus little accrued pension wealth before the age of 62. For those with long work careers the abolishment of the accrual ceiling may be important. Longevity adjustment will perhaps on its part postpone retirement, especially as it has been marketed and described in terms of the number of extra months each cohort needs to work in order to cancel the adjustment effect on pension. Other changes in the system will also affect the incentives to work or retire, if people know them and take them rationally into account, but there are opposing income and substitution effects so the net effects remain uncertain. The prefunding rules before the reform were as follows. A part of old-age pension benefits, payable after age 65, were funded for each employee. Funding took place between ages 23 55, so only benefits accrued during those years were (partially) funded. After the reform the rules are otherwise similar, but prefunding starts at age 18. Also some additional funding between was decided, amounting to 7.5 % of the insured wage sum in Apparently the trade unions demanded this temporary measure, at least partly to prevent a situation where current pension rules would have resulted in contributions being temporarily lower, followed by a sharp increase. The third change in funding is that the additional part in contributions, paid by employees aged 53 and over, is prefunded. The reform also changed the accrual rates and eligibility to benefits based on some nonsalary income (maternity, paternity and parent s allowance, earnings-related unemployment allowance and job alternation leave, sickness daily allowance etc). That part of the reform is financed by sources other than the pension contributions, which cover the rest of the system, and is not included in our analysis. 3. The method The economic framework that we use is an open economy version of the well-known Auerbach Kotlikoff - type numerical overlapping generations simulation model (Auerbach and Kotlikoff, 1987). The model consists of lifetime utility maximizing perfect foresight households, firms, foreign agents and a pension fund for both the private and public sector. The aggregate household sector consists of 14 contemporarily living (overlapping) 5-year birth cohorts of different ages and of three types of education (primary, secondary and tertiary). The dynamics of population ageing with births, deaths and migration as well as the strong improvement in the educational structure of the Finnish population is imitated closely with the model. The households make forward-looking decisions about consumption, saving, labour supply and bequests. The rules of the pension system influence the lifetime plans via several channels. The pension contributions distort labour supply during the working career, but the effect is dampened by the earned pension accruals. The possibilities as well as the need to save for old age are reduced due to the paid contributions and received pensions. The educational groups differ in the level and shape of their career earnings, their age when they enter the labour force, and when they retire. Entering and exiting the labour force takes place gradually, with those with only a basic education (and the lowest earnings) entering and retiring younger and those with better education and higher earnings entering 5 and exiting later. Differences in mortality rates between educational groups are not taken into account in the calculations. The model also generates new equilibrium price paths for labour, goods and capital markets and balances public sector expenditures and receipts with taxes after the reform. The changes in prices and taxes affect also the reactions of the households. The perfectly functioning labour markets of the model and the low elasticity of labour supply on wage changes imply that the incidence of the employers contributions is mainly on labour. Wages adjust to keep the employer s total labour costs almost the same. Separating the actual payer of the pension contribution is in this case meaningful only from the point of view of the tax authorities. A description of the whole adjustment path is essential, since the transition period in the pension reform is very long. A short overview of the model and the new pension rules are described in the Appendix. The model has been described also in Lassila and Valkonen (2003); a detailed description is available from the authors. The key assumption in our analysis is that the reform will postpone retirement. Although this is a necessary assumption for our model set-up, it is a rather plausible one as the reform both rewards longer work careers fiscally and makes early retirement more difficult. We assume that the effective age of retirement increases by well over a year in 20 years time. This is in line with several independent estimates of the deferral of retirement. The model is used to simulate the dynamic path of the economy before and after the pension reform and to compare the results. We get two types of results. The ones presented in Section 4.2 are based on expected demographic development, and they correspond to official evaluations of the impacts of the reform. We provide additional information to those because our model incorporates the behavioural responses of households and markets to the reform. The key numbers presented are the time paths of selected macroeconomic variables, the pension contribution and replacement rates, and generation-specific actuarity ratio. The actuarity ratio is the ratio of a cohort s discounted benefits from the pension system to its discounted sum of payments to the pension system. The benefits include old-age pensions, disability and unemployment pensions and all other pensions from the earningsrelated pension system. A ratio of 100 means that the cohort receives just what it pays, and a ratio below (above) 100 means that it gets less (more) than it pays. The second type of results, presented in Section 4.3, assesses the inter

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